The Economist, 10/14/10.
LIEUTENANT COLUMBO, the finest fictional detective in the history of the Los Angeles Police Department, had a knack for instantly identifying the culprit. Were he investigating the threat to American state finances, he would be looking at members of his own force. One California mayor estimates that the effective cost of employing each police officer and fireman is $180,000 a year.
That sum is not their take-home pay. For police and firefighters, the big costs occur when they stop working—retirement at 50, combined with inflation-linking, health benefits and lump sums for unused sick leave. Some might not begrudge perks given to those who put their lives on the line for fellow citizens. But California is also shelling out fortunes to retired state and municipal managers; more than 9,000 have retirement incomes of over $100,000 a year. Across America, states have been handing out such goodies for years (see article). Most public-sector workers are still being promised retirement incomes based on their final salaries, at a time when private companies have been retreating from such commitments.
America is not alone in having a pensions problem, as this week’s strikes in France demonstrate. But because America’s public-sector pensions funds are so enormous, the potential consequences of their problems are too. Meredith Whitney, a financial analyst who foretold the banking crisis, thinks America’s states could be the next source of systemic financial risk.
Calculating the potential exposure of taxpayers to pension promises is complicated. Much of the cost lies in the future, when existing employees retire. So a discount rate has to be applied to those future promises to calculate their present value. Following rules set down (rather shamefully) by the Government Accounting Standards Board, the individual states discount their pension liability by the assumed rate of return on the assets, in most cases around 8%.
This is “Alice-in-Wonderland accounting”, as David Crane, an economic adviser to California’s governor, Arnold Schwarzenegger, has remarked. For a start, pension schemes have not achieved such returns over the past decade of dismal stockmarkets, and are unlikely to do so in future. Nor do the liabilities disappear if the pension scheme fails to achieve its targeted returns. In many states, pension rights are legally protected. So a pension promise is a debt owed by the state; retirees may have even greater rights than a conventional creditor.
Given those conditions, the states’ pension promises should be discounted by the risk-free rate, or the yield on Treasury bonds. On that basis, total liabilities are $5.3 trillion, compared with $1.9 trillion of assets. The total shortfall of $3.4 trillion is the equivalent of a quarter of all federal debt.
Even on the basis of the dodgy accounting they currently use, the states have not funded their pension promises properly. Their finances are already coming under pressure from weak tax revenues; September’s employment data showed they are laying off staff. Balanced-budget requirements mean that filling the hole in pension schemes will absorb cash that would otherwise be used to provide services to citizens. It adds up to a dreadful mess. Some states may run out of the money to fund their pension schemes by the end of this decade.
At the very least, the accounting rules should be changed so that taxpayers are made aware of the promises they have underwritten. Perhaps they will be happy to keep funding them. But it is more likely that they will demand reform. Changing scheme rules for new employees is a start but will do nothing to reduce the size of the hole that has already been dug. The benefits of existing employees will have to be cut by, for example, increasing the retirement age. A move to career-average rather than final-salary benefits would cut the overall bill while protecting the lowest-paid.
None of this will be easy. Unions are at their most powerful in the public sector and its workers are an important voting block. Changes to their rights will be challenged in the courts. But it is high time to stop ignoring and obscuring the problem. The longer the system remains unchanged, the bigger the hole will get.
Link to full article: http://www.economist.com/node/17251840